KBRA Affirms Ratings for Orrstown Financial Services, Inc. Following Merger Announcement with Codorus Valley Bancorp, Inc.

KBRA affirms the senior unsecured debt rating of BBB, the subordinated debt rating of BBB-, and the short-term debt rating of K3 for Shippensburg, Pennsylvania-based Orrstown Financial Services, Inc. (NASDAQ: ORRF) (“the company”). In addition, KBRA affirms the deposit and senior unsecured debt ratings of BBB+, the subordinated debt rating of BBB, and the short-term deposit and debt ratings of K2 for the subsidiary, Orrstown Bank. The Outlook for all long-term ratings is Stable.

Key Credit Considerations

On December 12, 2023, Orrstown Financial Services, Inc. and York, Pennsylvania-based Codorus Valley Bancorp, Inc. (“CVLY”, not KBRA rated), the parent company of PeoplesBank, A Codorus Valley Company (“PeoplesBank”), announced a definitive agreement to combine in an all-stock merger of equals, which would create a $5.2 billion-asset banking institution and bolster scale across the contiguous Central and Eastern Pennsylvania footprint as well as throughout the Baltimore, Maryland MSA. Disclosed pro forma measures reflect total deposits of ~$4.5 billion, total loans of ~$4.0 billion, 51 combined branches, and total wealth management business assets under management of $2.7 billion. This transaction, with an announced total value of $207 million, incorporates key financial assumptions that, in addition to meaningful negative AOCI marks (~$38 million), include interest rate marks on loans of $76 million (~4.5% of CVLY’s total loans), and a currently projected gross loan credit mark of $14.2 million (~0.83% of CVLY’s HFI loans as of 3Q23). ORRF’s reasonable credit due diligence and loan sampling, which included third-party reviews, provide KBRA some comfort that projected credit marks seem adequate. With respect to post-closing management representation, ORRF’s CEO, Thomas Quinn, will become President and CEO of the combined company, while CVLY’s CEO, Craig Kauffman, will serve as EVP and Chief Operating Officer. With what we consider a thoughtful succession plan, management also disclosed that Mr. Quinn will retire from his executive roles on or around June 1, 2025 and be succeeded by Mr. Kauffman. Neil Kalani, ORRF’s current CFO, will serve as the CFO of the combined institution. Following the merger close, which is anticipated to occur in early 3Q24 subject to pending customary approvals, ORRF’s shareholders will own ~56% of the outstanding shares of the company with CVLY merging into ORRF and PeoplesBank merging into Orrstown Bank.

While the announced merger is transformative in terms of asset scale, KBRA considers the transaction consistent with ORRF’s stated long term strategies of targeted expansion into greater commercially-dense neighboring PA and MD markets, notably Lancaster, PA and Greater Baltimore. Additionally, merging two established wealth management platforms (with ORRF and CVLY managing $1.7 billion and $1.0 billion, respectively, in AUM) reinforces fee income scale and revenue diversification. Moreover, we do not expect much dilution in ORRF’s solid standalone funding profile, with both banking institutions reflecting comparatively lower deposit costs, similarly supported by a durable and historically lower-beta deposit base, and limited wholesale funding utilization. At 3Q23, pro forma core deposits represented over 90% of the total funding mix on a combined basis. Integration risk appears manageable in consideration of both companys' track records of mergers, complementary geographic footprint, and aligned credit cultures. The merger also presents sensible operating efficiency opportunities with cost saves projected to lower the combined noninterest expense base by 18%. Taken together, we expect the operating scale in conjunction with disciplined cost controls to meaningfully augment earnings power over the medium term. Driven by material interest rate marks and Day 2 CECL impacts, pro forma capital ratios are projected to fall materially, with management disclosing an estimated Tier 1 capital ratio of 9.5% and a TCE ratio of 6.8% post-closing. With that said, in consideration of strong core earnings capacity that will likely trend above many peers, we anticipate relatively solid pace of positive capital accretion towards peer-like levels within a reasonable time frame.

With respect to the balance sheet, loan segmentation will remain largely similar with relatively subtle differences in pro forma loan mix, with ORRF reflecting slightly higher C&I and CVLY holding modestly larger residential real estate and C&D portfolios. While we recognize that ORRF’s NPA ratio (~1.00% at 3Q23) is currently slightly elevated, which partly stems from COVID-related factors, credit losses have been well contained with ORRF’s annual NCO ratio averaging ~0.04% since 2015, owing to disciplined underwriting, a relatively granular loan portfolio, and a benign credit environment. CVLY’s current NPA ratio (0.43% at 3Q23) is manageable and partly buffered by the aforementioned credit marks. In terms of funding mix, unlike many KBRA rated peers, brokered deposit usage has been modest year-to-date and accounted for less than 1% of total deposits at both banks as of 3Q23 with only minimal corresponding increases in retail CDs and FHLB borrowings. We anticipate overall funding betas to track lower than peer trends over the medium term as both ORRF and CVLY have historically demonstrated.

Rating Sensitivities

Given the Stable Outlook, a rating upgrade is not likely in the intermediate term. Degradation in credit quality measures, whether from additional NPA formation or meaningful credit losses, substantial earnings weakness, unforeseen deterioration in the funding profile, inability to demonstrate positive CET1 ratio accretion to peer-like levels within a reasonable timeframe, or significant operational disruptions due to unexpected merger integration challenges could lead to rating pressure.

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